Gold, inflation & commodities

By Kurt Brouwer

I enjoy reading the thoughts of Scott Grannis at the Calafia Beach Pundit blog. I am passing along an interesting chart he created that shows a divergence between gold and a slew of other commodities. He believes the divergence suggests that commodities are going higher. I see two potential outcomes from this divergence, but more on that in a moment. First, here’s the chart:

In terms of commodities, Grannis makes the point that this divergence is bullish for commodity pricing [emphasis added]. The entire post can be found here:

This chart shows the relation between gold prices and the spot prices of non-energy industrial commodities (burlap, butter, cocoa beans, copper scrap, corn, cotton, hides, hogs, lard, lead scrap, print cloth, rosin, rubber, soybean oil, steel scrap, steers, sugar, tallow, tin, wheat, wool tops, zinc). The correlation between the two is pretty impressive, and it’s also noteworthy that gold prices tend to lead commodity prices by as much as a year or two.

The huge current gap between gold and commodity prices is just screaming to be addressed. Are we on the cusp of a major upturn in commodity prices? What is driving these prices higher: inflationary monetary policy or stronger global growth, or both? I don’t have solid answers, but the surge in gold prices in recent years, coming at a time when virtually all major central banks are pursuing accommodative money policy, suggests to me that the monetary explanation for higher commodity prices is the dominant one, though that certainly does not preclude increasing global demand as a factor. At the very least, as I mentioned in a recent post, I think this means deflation is dead. (The one-month drop in the January Core CPI notwithstanding; the big increases in PPI inflation at the crude and intermediate levels are pretty impressive, and a portent that inflation pressures will eventually make it to the consumer level.)…

I do not see a big surge in global demand for commodities coming any time soon. No doubt demand will increase over a longer period such as five or 10 years, but I just don’t see it in the next year or so. In terms of inflation, Grannis writes that the threat of deflation is over and higher inflation is on the way. I believe higher inflation may be coming too, but it is not here now.

To me, the threat of higher inflation is the main reason to consider investing in commodities. Governments of all stripes and persuasions love inflation and they hate deflation, so I have no doubt whatsoever that central bank bureaucrats everywhere are trying to crank up the inflationary pressure.

In terms of gold leading the way, I see a tale of two time periods in the chart. Gold is clearly leading the way for other commodities, but which way is it leading — down or up? When I look at the chart, it suggests that gold led commodities down from 1981 to 2001 or 2002. At that point, gold began leading on the upside.

As a cautionary note, I put forth what happened to gold just before the time period shown on the chart above:

Gold in 1980 — from darling to dog in two years

Gold hit a high point in 1980 of $875 per ounce, but it fell as low as $463 within a few months. Gold prices went back up into the $700 range, but by 1982, gold prices had fallen to a low of $298 per ounce. That’s right. From a high of $875, the price of gold fell to around $300 within a couple of years. Beginning in 1982, inflation fell quickly from the double digit level, but gold prices fell much more quickly as gold had a 60% price decline.

Buy commodities, but be careful

Is this a continuation of the bull market for commodities and gold? Maybe, but I would not bet the farm on it. We have seen that gold has been very strong for nine years or so. That factor alone suggests caution.

The point here is that I believe you need to make sure you are buying gold — or other commodities or any other asset — for good, solid, long-term reasons.

About Fundmastery Blog

Kurt Brouwer is a fee-only financial advisor with three decades of experience. He is the chairman and co-founder of Brouwer & Janachowski, LLC. Kurt has written books, articles and hundreds of blog posts on mutual funds, ETFs and other investment topics. E-mail: kurt.brouwer *at* gmail.com.